Practice Questions 6

• Review concepts covered in Chapters 18 and 19 of the fifth edition of Mishkin
• Review pros and cons of the three monetary policy tools available to the Fed: open market operations, discount loans, and reserve requirements

1. Identifications: Define and briefly explain the significance of each of the following terms:

Dynamic open market operations
Defensive open market operations
Primary dealers
Repurchase agreement of repos
Matched sale-purchase transactions
Reverse repos
TRAPS
Discount window
Adjustment credit loans
Seasonal credit
Extended credit
Moral suasion
Lender of last resort
Announcement effect
Penalty discount rate concept

2. True/False/or Uncertain. Briefly explain your answer.
a. The Fed can control the level of discount loans.
b. The reserve requirement is a flexible monetary policy tool.
c. The Fed is indifferent between using the discount policy and the reserve requirement in order to achieve a particular monetary policy goal.
d. The Federal Open Market Committee is the group that actually makes the decisions and executes the transactions involved in open market operations.
e. The Fed can influence the federal funds interest rate through its open market operations.
f. The discount rate and the federal funds rate differ by a constant amount.
g. Banks often make profits by going to the discount window and taking out relatively lower price loans from the Fed.
h. There is no limit to the level of discount loans available to banks since the Fed is the lender of last resort for the banking system.
i. The easiest monetary policy tool to implement from an administrative perspective is a change in the required reserve ratio.
j. The Fed pursues only defensive open market operations.
k. The Fed, if it is successful in implementing defensive open market operations, will have no need to pursue dynamic open market operations.
l. The existence of discount loans creates a moral hazard problem for the taxpayers with respect to bank behavior.
m. Extended credit discount loans are short-term loans offered to banks that face a severe reserve shortfall.

3. Essay Questions

1. How independent is the Federal Reserve? Based on the experiences of the Fed in the U.S., as well as other central banks, do you believe that the Fed should be independent? Provide both pros and cons in your argument.

2. What are the components of the monetary base? What are the components of the money multipliers? Critically assess the control of the Fed over the money supply, with respect to the monetary base and money multipliers. Be sure to discuss the degree to which the Fed can control each component of these two variables.

3. Compare the use of open market operations, discounting, and changes in reserve requirements to control the money supply on the following criteria: flexibility, reversibility, effectiveness, and speed of implementation.

4. The Fed used net free reserves as an operating target during the Depression. Why might this have been inadvisable?

5. "Interest rates can be measured more accurately and more quickly than the money supply. Hence an interest rate is preferred over the money supply as an intermediate target." Do you agree or disagree?

6. The Fed has most likely been targeting the real Federal Funds rate for the past ten years or so. What does this tell you about the relative volatility of money demand and money supply in the U.S.? What does it tell you about the relative stability of the financial and goods markets in the U.S.? How has the proliferation of financial instruments contributed to the choice of this target?